What’s the difference?
The concept of cash basis accounting is rather easy to understand: A business records an expense only when cash is spent and recognizes income only when cash is received. That’s pretty much it.
Accrual basis accounting on the other hand, is a bit more complex. When you use accrual accounting, your accounting system records an expense at the time it was incurred (even if it wasn’t paid for) and recognizes income when it is earned (but maybe not received). This method of accounting provides a more accurate picture of the timing of your business activities.
Example: Let’s say that JER Company sells $5000 of product in January. They get paid $3000 of that in January and $2000 in February. Then in February, sales are $4000 and they receive full payment of $4000 in February. On a cash basis, the accounting records will reflect income of $3000 in January and $6000 in February. It would appear as though sales were twice as much in February as they were in January; but the reality is that sales were about the same. Accrual accounting would reflect sales of $5000 in February with accounts receivable as of January 31 of $2000 and sales of $4000 in February with accounts receivable of $0 as of February 28.
For a small business (with average revenue of less than $1 million) either method is fine to use. Your choice of method will depend upon how detailed you would like your financial reports to be. Personally, I favor the accrual method of accounting because I like to provide my clients with the best, most accurate financial information possible.
Cash Accounting: Easy to Use
Small businesses – whether they are sole proprietors, partnerships, corporations or limited liability companies – often use cash accounting because it is simpler and more straightforward to apply. It provides a clear picture of how much money the business has on hand.
Accounting on a cash basis is good for small businesses that have fairly regular sales activity that is not affected by the seasons of the year or other cyclical events; sales that are paid for at the time of the sale; and expenses that are paid for when they happen and are not financed over time. Cash accounting is also good for small business owners who like to keep their record keeping simple and don’t require the formalities of generally accepted accounting principles or complex financial reports.
One downside to cash basis accounting is that it can make a business appear to be better off than it really is because cash accounting does not provide an accurate picture of outstanding liabilities (that is, expenses that have been incurred but not yet paid for). At the same time, using the cash method can make a business appear to not be doing as well as it really is; if, for example, a company has not yet been paid for a large job that was just completed. In that case, materials and labor may already have been paid for but the income has not yet been received.
Also, the cash basis of accounting can be used by companies that don’t maintain inventory. If your business is buying parts and/or materials for resale or to be incorporated into a product that you then sell, the IRS requires you to use the accrual method for sales and purchases.
Accrual Accounting: More Accurate Reporting
It is very difficult to maintain cash basis accounting records that present a complete picture of a company’s business operations. So the accounting world created the accrual method of accounting.
Accrual accounting is based upon the “matching principal.” It matches income and expenses to the time period in which they were incurred. In some instances, it also attempts to match sales revenue to the expenses that were incurred to generate it.
Accrual accounting is good for any size business that does experience sales activity and expenses that are affected by cyclical events; that sells products or services or purchases materials on account; that is subject to annual audits; or whose owner or owners would like detailed financial reports.
C Corporations, however, are generally required to use accrual accounting if their average annual gross income for the previous three years was more than $5 million.
While the accrual method provides a more accurate picture of the timing of your business’ activities, it may leave you unaware as to how much cash you actually have available; this could result in a serious cash flow problem. For example, your company’s sales figures for the month may indicate $8000 in sales however, your bank account could be almost empty because your customers haven’t paid you yet.
What’s your preference?
The accrual method of accounting is more widely used because it produces more accurate and detailed financial reports that provide a better representation of your business’ financial performance. It helps the business owner with better financial management and planning.
However, it requires more precise data entry which in turn, requires that more time be spent on bookkeeping. As a business owner, if you don’t have the skills or time to devote to the task, I recommend you hire it out.
The cash method of accounting can be quick and easy and doesn’t require as much time for bookkeeping work. This makes it more suited to a single-owner entity who doesn’t need complex financial reporting and at least knows how to operate the accounting software he has purchased.